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Financial Stability Report July 2006 | Issue No.20

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Financial Stability Report July 2006 | Issue No.20 Financial Stability Report July 2006 | Issue No.20 Financial Stability Report July 2006 1 BANK OF ENGLAND Financial Stability Report July 2006 | Issue No. 20 The Bank of England has two core purposes — monetary stability and financial stability. The two are connected because serious disruption in the financial system would affect the implementation and effectiveness of monetary policy, while macroeconomic stability helps reduce risks to financial stability. The Bank’s responsibilities for monetary stability are set out in the Bank of England Act 1998. Responsibility for financial stability in the United Kingdom is shared between the tripartite authorities — HM Treasury, the Financial Services Authority (FSA) and the Bank of England. Their roles are set out in a Memorandum of Understanding (MoU).(1) The Bank’s responsibility for contributing to the maintenance of the stability of the financial system as a whole derives from its responsibility for setting and implementing monetary policy, its role in respect of payment systems in the United Kingdom and its operational role as banker to the banking system. The Bank aims to bring its expertise in economic analysis and its experience as a participant in financial markets to the assessment and mitigation of risks to the UK financial system including, if necessary, helping to manage and resolve financial crises. The Financial Stability Report aims to identify the major downside risks to the UK financial system and thereby help financial firms, authorities overseas and the wider public in managing and preparing for these risks. The Report is produced half-yearly by Bank staff under the guidance of the Bank’s Financial Stability Board, whose best collective judgement it represents. The Financial Stability Board: Sir John Gieve, Chair Andrew Bailey Charles Bean Alastair Clark Nigel Jenkinson Mervyn King Rachel Lomax Paul Tucker The Financial Stability Report is available in PDF at www.bankofengland.co.uk. (1) The tripartite Memorandum of Understanding was revised in March 2006 and is available at www.bankofengland.co.uk/financialstability/mou.pdf. Financial Stability Report July 2006 3 Contents Foreword 1 Overview 5 1 Shocks to the UK financial system 14 Box 1 The fall and rise in major government bond yields 20 Box 2 Collateralised debt obligations and risk 21 2 Structure of the UK financial system 24 Box 3 Trading revenues and Value-at-Risk 27 Box 4 Leverage 32 Box 5 Financial market amplifiers 33 3 Prospects for the UK financial system 36 Box 6 Systemic stress testing 45 Box 7 Risk transmission in the Russian and LTCM crises 50 4 Mitigating risks to the UK financial system 51 Box 8 Risk assessment and crisis management 58 Other financial stability publications 62 Index of charts and tables 64 Glossary and other information 66 Overview 5 Overview The Bank has made a number of changes since the December 2005 FSR, with the aim of providing a clearer, forward-looking synthesis of the key risks to the UK financial system. This is reflected in renaming this publication the Financial Stability Report. Section 1 of the Report assesses how macroeconomic and financial developments over the past six months have affected risks to the UK financial system, while Section 2 reviews changes in the structure of the system over this period. Section 3 provides the Bank’s assessment of key vulnerabilities in the light of those developments. Finally, Section 4 links this risk assessment to the mitigating actions that might be undertaken. Risk-taking behaviour has swung markedly during the past six months. The early months of the year saw an intensification of risk taking and a corresponding rise in asset prices globally. Since May, risk appetites appear to have diminished somewhat and some asset prices have retraced their path. The profitability of the UK financial system remains high, helping to underpin its resilience to future disturbances. But the risks associated with the key vulnerabilities, while remote, have increased somewhat and remain significant. What are the main vulnerabilities? The Bank focuses on the resilience of the UK financial system as a whole, concentrating on the major UK banks, markets and infrastructures — not because that is where problems are most likely, but because an incident elsewhere is unlikely to have a system-wide impact in the United Kingdom unless it affects them. 6 Financial Stability Report July 2006 Financial markets are inherently volatile and there are always winners and losers within the financial system. But the UK financial system as a whole has been remarkably resilient over recent years in the face of a number of disturbances, including oil and commodity price shocks and, most recently, sharp falls in the prices of some risky assets. Several structural developments have helped to strengthen the system over time, including high profits and capital, continuing improvements in risk management and more sophisticated ways of distributing risk. The Bank’s responsibility is not just to consider the most likely outcome but also to assess major downside risks. By their nature, these risks are likely to be low probability events in the tail of the distribution of possible outcomes. The fact that these risks are unlikely does not mean, however, they should be ignored. The Bank works collaboratively with HM Treasury (HMT) and the Financial Services Authority (FSA) to reduce the probability and impact of these remote risks and to prepare contingency plans for handling them should they crystallise. The Monetary Policy Committee’s (MPC) projections for the UK economy are set out in the May Inflation Report. They show steady growth close to trend and inflation around the 2% target. This Report, while entirely consistent with that outlook, does not focus on forecasts of the most probable outcome for the financial system. Rather, it identifies underlying vulnerabilities that could, in improbable but plausible circumstances, generate risks to the UK financial system. In considering these risks, it is helpful to distinguish the underlying sources of vulnerability within the system and the particular events that might trigger them. There are many events that are possible triggers, including avian flu, further oil price rises and heightened geopolitical risk. Whether they would in fact cause a problem for the UK financial system depends on its underlying health and structure. In this Report, six main sources of vulnerability are explored. None of them is new and most are long standing. Although these vulnerabilities are unlikely to crystallise, either individually or in combination, the consequences for the UK financial system if they did could be material. Their characteristics differ. Some arise from potential mismatches or mispricing in international financial markets. Others are rooted in extended balance sheet positions in parts of the non-financial sector. Others still reflect structural dependencies within the UK financial system. They can be grouped under three headings: Overview 7 Vulnerabilities in international financial markets • The unusually low premia for bearing risk presently prevailing across a range of asset markets, notwithstanding recent market movements. In part, this may reflect improved fundamentals and more efficient markets over recent years. But if risk premia rose abruptly, asset prices would fall sharply. • Large financial imbalances among the major economies have continued over the past six months. These may unwind in an orderly fashion; but there is a risk of disorderly unwinding, which could conceivably crystallise credit and market risks. Extended non-financial sector balance sheets • Rapid releveraging in parts of the corporate sector globally — for example, among commercial property companies or arising as a result of leveraged buyouts. Against a background of possibly underpriced corporate credit risk, this releveraging could widen and deepen over time. • High UK household sector indebtedness in relation to income. Household balance sheets look strong in aggregate, but there are signs of stress among a minority of households, with personal insolvencies rising sharply. Structural dependencies within the financial system • Rising systemic importance of large complex financial institutions (LCFIs) given their pivotal position in global capital markets and increasing links with UK banks. Their balance sheets and risk-taking activities also appear to be expanding. • Dependence of UK financial institutions on market infrastructures and utilities for clearing and settling payments and financial transactions, whose contingency plans in the event of any disruption to their services may be inadequately understood and tested by some users. The following sections of the Report assess news over the period relating to these areas of vulnerability (Sections 1 and 2), the scale of risk to the UK financial system (Section 3), and how those risks might be mitigated (Section 4). How have the vulnerabilities changed? The financial environment over the past six months has swung significantly. The early months of the year were characterised by increased risk taking and a further fall in the price of risk; the latter months by some scaling back of risk taking and a retreat in some asset prices. Even so, most asset prices remain a little higher than in December, though uncertainties around them are also greater. 8 Financial Stability Report July 2006 Chart 1 UK banks’ write-offs remain low(a)(b)(c) Low macroeconomic risk helps boost asset prices… During the early months of this year, the macroeconomic Mortgage Total household(d) Credit card Corporate environment, in the United Kingdom and globally, remained Other unsecured Per cent 5.5 benign. Against that backdrop, the balance sheets of UK 5.0 households and companies did not look especially stretched in 4.5 aggregate. This contributed to historically low realised credit 4.0 losses on UK banks’ household and corporate exposures. 3.5 Although write-off rates on unsecured loans to households 3.0 have increased sharply, aggregate write-off rates on household 2.5 and corporate loans are little different from a year ago 2.0 (Chart 1).
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